What Are Risk-Weighted Assets, and Why Do They Matter to Bank Investors?

One of the most dramatic changes to the banking industry since the financial crisis is the rollout of new capital requirements for banks. Banks today are required to hold higher levels of capital, dictated by complex accounting rules that very few investors truly understand.

A central part to this new calculation is a concept called risk-weighted assets. In its minutiae, calculating a bank's risk-weighted assets is a nightmare. We won't do that here. Instead we'll focus on what it means more generally, and why that understanding is really important to understanding a bank's balance sheet.

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Capital, risk-weighted assets, and a potentially bad headacheI don't think anyone would argue that a bank shouldn't be required to maintain certain capital levels on its balance sheet. That capital protects the bank from losses and ultimately protects taxpayers from potentially expensive bailouts. How to regulate that capital level though is a bit more complex.

The simplest approach would be to require all banks to maintain a maximum leverage ratio -- something like the assets-to-shareholder equity ratio. It would be simple, everyone could understand it, and there would be no question which banks were overly leveraged.

The problem with the simple ratio approach is that it leaves a not-so-obvious gap on the asset side of the balance sheet. Consider two hypothetical banks, both with $50 billion in total assets.

Bank A has 50% Treasuries, 25% loans, 15% in branches and buildings, and 10% in cash. That's a pretty conservative balance sheet. Bank B though could have 50% in loans, 29% in weird derivatives, 20% in branches, and 1% in cash. That's a whole lot more risk.

Using the assets-to-shareholder equity approach, Bank B would in theory have the same capital requirement as Bank A, even though it is so clearly a more risky institution. That simple approach doesn't recognize that a subprime loan is more risky than a U.S. T-Note.

Regulators recognized this and concluded that the best way to guarantee that a bank has adequate capital is to force banks to take that varying risk into account. And thus, risk-weighted assets were born.

How it works, in practiceUsing fancy accounting models far outside the scope of this article, banks and regulators calculate exactly how risky each asset set is and then determine an appropriate level of capital that must be available to back that asset. Even many off balance sheet items carry a risk weighting, like the available credit on your home equity line of credit as an example.

Let's break it down with another example. Cash and Treasuries, we agree, have little if any risk. Therefore, banks could reasonably assign them no risk and reserve no capital. A subprime loan that is 90 days past due on its payments, however, may require a capital reserve of 50% or more.

Banks go through this process for the entire asset side of the balance sheet and add up all the capital required based on the assigned risk weightings. That sum is the minimum required capital level for that bank.

The implication for return on equity, and why this matters a lot for bank investorsA byproduct of this framework is a new game for reaching return on equity objectives. With capital requirements explicitly linked to risk, we as investors must up our game to understand exactly how management constructs the asset side of the balance sheet.

On one hand, a bank can pile into highly rated corporate bonds -- low-yielding assets that require little capital reserves. Or perhaps the bank chooses highly rated sovereign debt, which also carries a low risk rating and therefore a lower capital requirement. Even with the very low yields available in these assets, the low capital requirements make the return-on-equity proposition attractive.

But what would happen if there was a bear market in corporate bonds? Or if a global economic crisis, like the current oil issues plaguing Russia, suddenly put those foreign assets at risk? Or worse yet, what if all banks bought in and unknowingly drove a bubble in these seemingly safe assets?

Banks that attempt to game return on equity could very easily find themselves overconcentrated on a certain asset -- one that may have been deemed as "safe" just before it wasn't. Investors, beware; these risks are real.

Foolish takeawayThe solution for the bank investor is to make sure that you fully understand what assets the bank actually holds, at least as much as is possible. I recommend using the bank's regulatory filings known as "call reports". You can compare that with the rest of the industry using the FDIC's Quarterly Banking Profile.

Ask yourself: Is the bank holding an abnormal level of cash, Treasuries, or other asset type? If so, make sure you understand why. Is the bank overweight in a specific loan type like commercial real estate? If so, are you comfortable with the bank's expertise and experience in that arena? Do you understand what each asset is, how it helps the bank earn, and what risk comes with it?

Your best bet is to find banks with diversified earning assets coupled with efficient operations. Those banks will have plenty of earnings, without unnecessary concentrations or risky assets, and they will have the efficiency to ensure that the profits and returns take care of themselves.